Global economic policymakers are likely to see the sudden sell-off in risky assets on Tuesday as out of proportion to the relatively modest crack in global growth prospects represented by the fall in US durable goods orders and a crackdown by China’s stock market regulators.
It is likely that the Federal Reserve and other central banks will be a good deal less shaken than the markets and continue to take a cautiously optimistic view of the economic outlook.
Nonetheless, developments in financial markets will be closely watched by policymakers, and could conceivably have significant consequences for the real economy and interest rates.
Much depends on whether Tuesday’s sell-off proves to be an isolated event, the start of a period of heightened risk aversion that ultimately proves transitory – similar to last Spring – or the beginning of a more enduring shift in risk appetite.
“You just do not know at this stage whether this is a harbinger of a general rise in risk aversion and increase in risk spreads or not,” says Ted Truman, a former assistant US Treasury secretary now at the Peterson Institute.
It also matters enormously whether or not any shift in risk appetite is orderly, and whether it has any impact on business and consumer confidence.
Policymakers will be on the lookout for signs of disorderly contagion spreading from the US subprime mortgage market through emerging markets to other risky asset classes.
Contagion can take place when markets are linked by common investors (such as hedge funds) or common funding strategies (such as the yen carry trade), even if they do not share common fundamentals or economic linkages.
Raghuram Rajan, a professor at University of Chicago who recently stepped down as chief economist of the International Monetary Fund, says there is little hard evidence that investors hurt by the crisis in the US sub-prime market are dumping Chinese and other emerging market stocks.
“I do not think the same guys are in China,” he says. The run-up in the Chinese equity market has been largely driven by individual Chinese investors, he says, although investor linkages may be greater with emerging market debt.
Mr Rajan says rising risk aversion need not be too harmful to the world economy providing investment funds are able to absorb their losses, and honour their debts to banks and other systemically important institutions.
“If institutions get into trouble then all bets are off,” he says.
Charles Dallara, managing director of the Institute of International Finance, a lobby group representing the world’s big lenders, says: “We are obviously seeing increasing signs of global market connectedness here.”
He thinks the sell-off in the sub-prime market was a wake-up call, reminding investors that the price of risk had been driven down to unsustainably low levels across the board.
Policymakers will be reassured by the apparently modest link between Tuesday’s shift in risk appetite and global macroeconomic fundamentals, although that could change if further negative data accumulated.
Absent this, a big default or a major spillover into confidence, their focus will be on the impact of financial market developments on monetary conditions.
In the case of the US at least, this is not a one-way bet. Tighter credit spreads and lower equities tighten monetary conditions.
But the safe-haven flight into US bonds, which drove down yields, and Tuesday’s big swing in the Fed funds futures market towards pricing in a greater likelihood of rate cuts, have the reverse effect, loosening monetary conditions.
It is not obvious that the net result will indeed be to push the Fed in the direction of cutting interest rates.
